Chapter 7: Fundamentals of Capital Budgeting

Summary

1. 2. 3. 4. a. b. c. d. 5. 6.

Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept. A capital budget is a list of all projects that a company plans to undertake during the next period. We use the NPV rule to evaluate capital budgeting decisions, making decisions that maximize NPV. When deciding to accept or reject a project, we accept projects with a positive NPV. The incremental earnings of a project comprise the amount by which the project is expected to change the firms earnings.,p> Incremental earnings should include all incremental revenues and costs associated with the project, including project externalities and opportunity costs, but excluding sunk costs and interest expenses. Project externalities are cash flows that occur when a project affects other areas of the companys business. An opportunity cost is the cost of using an existing asset, measured by the value the asset would have provided in its best alternative use. A sunk cost is an unrecoverable cost that has already been incurred. Interest and other financing-related expenses are excluded to determine the projects unlevered net income. We estimate taxes using the marginal tax rate, based on the net income generated by the rest of the firms operations, as well as any tax loss carrybacks or carryforwards. When evaluating a capital budgeting decision, we first consider the project on its own, separate from the decision regarding how to finance the project.Thus, we ignore interest expenses and compute the unlevered net income contribution of the project:

7. a. b. c.

We compute free cash flow from incremental earnings by eliminating all non-cash expenses and including all capital investment. Depreciation is not a cash expense, so it is added back. Actual capital expenditures are deducted. Increases in net working capital are deducted. Net working capital is defined as

8.

9.

The basic calculation for free cash flow is

10. 11. 12. 13.

14. 15. 16. 17. 18.

The discount rate for a project is its cost of capital: The expected return of securities with comparable risk and horizon. When choosing between alternatives, we only need to include those components of free cash flow that differ among the alternatives. Depreciation expenses affect free cash flow only through the depreciation tax shield. The firm should generally use the most accelerated depreciation schedule that is allowable for tax purposes. Free cash flow should also include the (after-tax) liquidation or salvage value of any assets that are disposed of. It may also include a terminal (continuation) value if the project continues beyond the forecast horizon. When an asset is sold, tax is due on the difference between the sale price and the assets book value net of depreciation. Terminal or continuation values should reflect the present value of the projects future cash flows beyond the forecast horizon. Break-even analysis computes the level of a parameter that makes the projects NPV equal zero. Sensitivity analysis breaks the NPV calculation down into its component assumptions, showing how the NPV varies as the values of the underlying assumptions change. Scenario analysis considers the effect of changing multiple parameters simultaneously.